Going for a 1031 tax exchange is always beneficial to investors. However, the road towards it isn’t clear-cut and smooth. At least, if you’re not knowledgable about the implications of this tax deferral advantage.
Below are some of the main benefits of a 1031 exchange, and other important facts about this IRS code.
What You Can Get Out Of A 1031 Exchange
There’s one main benefit that investors are able to obtain from a successful 1031 exchange, and that’s tax deferral. A “tax deferral” is defined as delaying the payment of the tax itself, over a certain period of time.
Why is the Internal Revenue Service’s 1031 Code beneficial in property investments? A straightforward and practical explanation is that you can make good use of said timeframe to accumulate funds and grow your income. Then, you can allot a percentage towards taxes until their actual date of payment.
In the event that you have urgent and outstanding financial needs at present, it will prove helpful. This is referred to as tempering the tax impact on your income and/ or capital gains.
Secondly, there’s a possibility for the tax rate to decrease in the future. Again, it’s a “possibility”. It isn’t a fixed rule. At the same time, there are certain regulations regarding what kind of taxes will either be allowed or disallowed for rate-lowering.
Thirdly, there’s also a possibility for the deferral to be indefinite, even to the point of no longer having to pay for it. Though much like what we’ve mentioned about rate lowering, the same is true when it comes to indefinite deferral— there are very specific qualifiers for an exchange to be justified for this bonus.
Implications Of Depreciation
Considered crucial in a 1031 exchange, depreciation tells of a percentage that’s written off the actual cost of a property. This, as related to said investment properties’ deterioration due to natural wear and tear, over time.
It’s a situation that all types of properties (and most kinds of tangible assets, at that) eventually face, at one point or another.
Once an investment property has been sold and its ownership, transferred to the buyer, the capital gains taxes will be levelled to its net-adjusted criterion. Therefore, we’re talking about its original purchase cost, with the add-on of capital improvements, and with depreciation automatically deducted from the whole.
If you resell the property with a price tag that’s higher than its depreciation value, there’s a need to “recapture” the latter. In other words, the depreciation amount will have a place in your taxable income (as from the property sale).
Now, there is a correlation between the way the size of the depreciation continuously increments as time goes by and how recapturing it, later on, would mean a larger sum you’d have to pay towards your taxable income.
Because of this, and speaking within the context of depreciation alone, investors choose to go by the 1031 exchange route. In doing so, paying for the hefty increase as a result of the recapture can be legally avoided.
Thus, depreciation is a variable that should be carefully taken into account, especially when calculating both the value of the property and of the depreciation recapture.
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